Draghi’s Unlimited Loans Are No Panacea

European Central Bank President
Mario Draghi’s success in quelling a bond-market rout across the
euro region’s periphery masks a failure by the region’s banks to
bolster their capital.

The ECB will offer a second round of unlimited three-year
funds on Feb. 29. Firms will seek 470 billion euros ($629
billion), approaching the 489 billion euro take-up by 500 banks
at the first long-term refinancing operation on Dec. 21, the
median estimate of 28 analysts surveyed by Bloomberg show.

“The worry is it may act to keep afloat institutions that
aren’t exactly viable,” said Stewart Robertson, chief European
economist at Aviva Investors in London, which manages more than
$425 billion. “This buys time for banks, but does it really
provide them with an incentive to sort out their books? The
worry is it doesn’t.”

The Frankfurt-based central bank is flooding the market
with cheap money to head off a credit crunch, boost lending to
companies and consumers, and spur demand for unsecured bank
debt. Rates on two-year Spanish notes have fallen 241 basis
points to 2.56 percent since the first offer was announced on
Dec. 8 and Italian yields have shed 336 basis points to 2.79
percent.

False Security

“Providing money so cheaply, for so long, against what is
now effectively any collateral whatever, leaves the ECB in a
position no central bank would choose to be in,” UBS AG
analysts led by London-based Alastair Ryan said in a Feb. 22
note to clients. “It cannot control the credit risk coming onto
its books, or at least onto the books of its national central
banks. Worse, the success of its interventions risks encouraging
politicians to avoid making necessary but difficult decisions.”

Banks can borrow from the ECB at 1 percent and invest the
proceeds in 10-year Italian government bonds yielding 5.49
percent. While that so-called carry trade will help boost banks’
income, it makes them more vulnerable to a decline in the value
of government debt. It also may become costlier for banks to
obtain longer-term funding because ECB loans are senior to
claims from other lenders.

“You are gradually putting private traders at a lower
level in the capital structure and at higher risk, if things go
wrong,” said Alberto Gallo, head of European credit strategy at
Royal Bank of Scotland Group Plc in London.

Spanish banks boosted their holdings of domestic government
debt by 15 percent in December and Irish banks raised their
holdings of Irish sovereign debt by 6 percent, he said. “This
is a carry trade that increases banks’ exposure and correlation
to sovereigns,” Gallo said.

Overnight Parking

Rather than heed calls by politicians to boost lending to
companies and consumers, some banks are choosing to deposit the
money in the ECB’s overnight facility at a rate of 0.25 percent
until they need it to refinance maturing debt. Deposits with the
central bank rose to a record 528 billion euros on Jan. 17 and
were at 477 billion euros at the end of last week, according to
ECB data.

“This will ease credit flows but won’t stop the great
deleveraging,” Huw van Steenis, an analyst at Morgan Stanley in
London, wrote in a note to clients. “LTRO is important but not
a panacea. While the LTRO should materially ease the euro zone
deleveraging process, credit conditions appear likely to remain
fairly tight in Spain, Italy and central and eastern Europe.”

Intesa Sanpaolo SpA sold 1.5 billion euros of 18-month
senior unsecured bonds last month with a yield of about 4.1
percent or 295 basis points more than the mid-swap rate. Lloyds
Banking Group Plc, based in London, raised 1.5 billion euros
from a five-year offering Jan. 26. It priced the bonds to yield
4.1 percent, or 305 basis points more than the benchmark swap
rate.

“The crisis will only be resolved when, and if, European
banks are sufficiently recapitalized to render a Greek default,
and the concomitant peripheral contagion containable,” Danny Gabay and Yiannis Koutelidakis, London-based economists at
Fathom Consulting, said in a note to clients last week.
“European politicians have been lulled into a false sense of
security by the market’s euphoric reaction” to the LTRO, they
wrote.

Growing Risk

Banks also are cutting lending outside their home markets,
data compiled by the Bank for International Settlements show.
Euro-area banks reduced lending to Asia by 9 percent and to
central and Eastern Europe by 8 percent in the third quarter.

“While the two three-year LTRO tenders establish a
relatively long period for the industry to adjust, the ECB exit,
in our opinion, represents a large risk that will grow over the
coming three years as the first quarter 2015 maturity of the
three-year LTRO approaches,” rating company Standard & Poor’s
said in a Feb. 21 note.